UNFAIR VALUE

I want to draw attention of the equity analysts in the group to apuzzling proximity in the housing lone rates and rates on govt. bonds.As you all know the govt. bond are the safest form of fixed incomeinstruments and housing loans suffer from the risk of defaults.

The risk premium ranges from 1.45% to 1.69%. Especially in short termloans the figure seems low. For instance if 7.5% of the housing loansdefault the banks/housing finance companies(HFCs) would get returnsless than the govt bonds. Any further rise in interest rates willchange the equation further.

Here I have not taken into account the selling and administrativeexpenses incurred by banks on selling these loan products.It would beinteresting to gather data on whether the banks/HFCs are able to getthe promotion /selling/ administration expenses from the upfront feethey charge apart from the interest. In personal loans it's quitecommon to charge 2% upfront and I'm unable to get data about theupfront fees in housing loans.

Thus every thing depends on what is the level of risk in housing loan.The risk in any fixed income security is covered in 2 ways.1) By securing loans with assets. This means that a bank/HFC shouldgive a loan worth less than the value of property. Considering highprices of real estate the banks should keep adequate margin of safety2) The income of the person purchasing loan product: The personavailing the loan should have an income sufficient to meet hisinterest payments. In case of corporate customers income to interestratio (interest cover) of less than 3 is considered risky. In case ofindividuals I thing that the interest coverage should be more than 5.Another point to consider here is that the earning of acompany is net of all costs where the income of a person is gross.While giving loans only the income is counted and any accounting ofexpenses, though logical, is impractical.

On both these counts, I think, banks/HFCs are throwing caution to thewind. In a competitive market where the employees have to meet theirtargets such a result is not unnatural. I have read in the papers thatthe banks are now giving loans up to 80-90% of the value of property.They are giving loans to persons who have income barely twice theinterest payment.

RBI has also cautioned the banks in a measured way. The Monetarypolicy contained the following statements"The fast growing housing and consumer credit sectors also representsome degree of higher penetration, but the quality of lending needs tobe ensured".... It is observed in the recent past that the growth ofhousing and consumer credit has been very strong. As a temporarycounter cyclical measure, it is proposed to put in place, riskcontainment measures and increase the risk weight from 50 per cent to75 per cent in the case of housing loans and from 100 per cent to 125per cent in the case of consumer credit including personal loans andcredit cards"

If such concerns are really valid and remain unaddressed, the retailcredit boom may well leave banks with similar amount of NPAs whichthey accumulated on industrial credit boom in 90's.